Why the weak dollar means you should buy into gold

published 21 August 2006

Until Thursday's bomb alert, the pound had been riding at near 18-month highs against the dollar. The press is full of speculation as to whether the $2 mark will be breached any time soon.

Certainly, the fact that UK interest rates look set to rise further, while the Federal Reserve has currently put rates on pause, could mean the pound's position of strength will continue in the short term. Research by George Saravelos and Trevor Dinmore of Deutsche Bank suggests the dollar is more vulnerable to problems such as a weakening economy or an expanding trade deficit once interest rates have stopped rising.

This makes perfect sense after all, rising interest rates improve the return available to investors who buy into the dollar. If interest rates stop rising, investors are more likely to pay attention to the underlying condition of the US economy. And the trouble is that news from that direction is not pretty.

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Go for gold: US in debt

Just like its citizens, the US as a country is massively in debt. The current account deficit is standing at around 6% of economic growth, well above what most economists believe is sustainable.

Part of the reason that the dollar has managed to remain steady for so long is that central banks in Asia, such as Japan and China, have bought dollars to prevent their own currencies from appreciating.

This keeps their exports cheap, which means that US consumers keep buying their goods. In other words, Asian countries are lending Americans money, which Americans then use to buy goods back from Asian producers.

This is clearly unsustainable at some point the US will need to pay its creditors back. And neither Japan nor China are likely to be interested in propping up the US consumer for much longer.

Go for gold: consumer confidence crumbling

One problem is that the US consumer is now starting to falter under the pressure of rising energy prices and a shaky-looking housing market. US consumers have been spending more than they earn on a monthly basis - for more than a year now. But with future house price gains now looking in doubt, the funding for all that extra spending is under threat.

Consumption accounts for nearly 70% of US economic growth. So if the US consumer stops spending, the US economy will almost certainly go into a slump. And that will make US assets less attractive to overseas buyers.

Go for gold: Asian giants on the rise

On the other hand, Japan's economic revival is now in little doubt. As prices rise and consumers regain their confidence, the focus for economic growth will turn to domestic consumers rather than overseas ones.

As for China, it too is trying to push its economy from being one reliant on manufacturing and exports, to one driven by consumer spending. Again, this will involve allowing its currency to strengthen, which can only be bad news for the dollar.

The International Monetary Fund reckons the greenback will have to fall by at least 35% to shrink the US trade deficit in any meaningful way. With interest rates on hold, and the US economy looking increasingly weaker, that day may be closer than most investors realise.

But as for sterling remaining near $2 a pound, that may not last long either. With a similar-sized trade deficit in relation to our economy, and consumers struggling under a record debt burden, our own situation isn't so different to that of the US.

Go for gold: protect your portfolio

So where can investors go to protect their portfolios - and perhaps even make money out of currency weakness? Gold is the answer.

The price of gold has soared in recent years as record-breaking oil prices, fear of inflation and geopolitical uncertainty have made it attractive to investors who want to have some form of insurance for their portfolios. Gold is traditionally seen as a good store of wealth although it pays no interest or dividends, it tends to retain its value in the face of inflation.

And with central banks still printing out money like there's no tomorrow, the number of pounds and dollars in the world compared to the number of ounces of gold just keep rising which tends to push the price of gold up too.

Indeed, more and more central banks, including Russia's and China's have announced their intention to diversify away from dollars and increase their gold reserves.Canny investors should consider doing the same broadly speaking, experts recommend having about 10% exposure to gold in your portfolio.

First published on MSN Money 14/8/2006

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.